IN a move that several market analysts have been predicting for nearly a year now, the Federal Reserve agreed on Wednesday to initiate what could be viewed as the first phase in the reduction of Quantitative Easing or “tapering”. The Fed has decided to reduce bond purchases from US$85 billion per month to US$75 billion, primarily as a result of improvements in the labour market. Purchases will be split between treasuries (US$40 billion) and mortgage bonds (US$35 billion) commencing in January 2014. This represents a decline of US$5 billion in each category.

MarketWatch.com listed the top nicknames for the Fed’s action on Wednesday. Interesting terms such as “taperette”, “tip toe taper” and “mild taper” probably best describe the move by the Fed which could also be described as timid. Despite improved employment data, the Board of Governors still believe that there is sufficient weakness in the labour market and GDP growth to rule out a more aggressive taper. The other key indicator that concerns the Fed is the outlook for inflation. We have mentioned in previous articles that inflation levels remain fairly low, and lower levels could lead to Japanese-style deflation if economic growth were to lag behind target rates. There is still a view that tapering should not begin as early as January, as the GDP data was still lagging behind pre-Crisis levels and further slippage would result in possible deflation. It is also likely that there will be little change in the Fed funds rate even if unemployment levels fall below the 6.5% market, which has been a benchmark from previous minutes.

The talks of tapering have created some measure of volatility in the bond market and have fed into the fears of potential bond purchasers. The US ten-year treasury yield one year ago was at one-handle up until May of this year and peaked at nearly three per cent in September 2013. There has been concern by some fund managers that once the Fed began tapering, bond yields would climb, deflating bond prices and reducing portfolio returns. The data so far has proven somewhat to the contrary; despite the more than 100 basis point rise in treasury yields over the last twelve months, several managed bond portfolios have beaten expectations and given investors double-digit returns. Data also suggests that even with the spike in Treasury yields year to date, the market has priced in the expectation of tapering in bond prices and there has not been a widespread collapse in bond prices. It is still somewhat harder to determine the impact of the Fed’s action on Sovereign bonds. This is especially relevant in the case of Jamaica because nearly 80 per cent of those bonds are held by locals and trading dynamics differ from other international bonds with more diverse ownership.

The US stock market, as expected, reacted positively to this news, as. The Dow and the S&P rallied to record highs. The Dow jumped by 290 points on Wednesday, in stark contrast to what happened back in June when the first talks of tapering began. Perhaps one could view those early talks as being premature as it would have taken six months for any measure of tapering to occur and still only a modest taper was contemplated. Ironically, tapering should be viewed as a good sign implying that the economic recovery is on track and that should augur well for stocks. We are yet to figure out how much of the “easy money” injected during quantitative easing is fuelling the stock bubble. In theory, all the signals are right for a surge in stock prices: lower unemployment, modest inflation, rising bond yields, and improving GDP numbers. However, a more aggressive taper would stymie a bull run that now enters its fifth year.

In all of this, the Fed has indicated that there is no cookie-cutter strategy that can be employed. All decisions will be made in line with the changes in the outlook of Fed members. What is important to note is that Janet Yellen, the assumed next Fed Chairman, is in lock step with the plan for this “tip toe” taper. Although this is slated to commence before Bernanke’s swan song, it is yet to be seen how aggressive a Yellen-Chaired Fed is likely to be with even more modest changes in outlook. However, given that the Fed’s balance sheet has swelled to nearly US$4 trillion, since the start of Quantitative Easing, raw economic data may not be the only factors affecting their decisions.

What is very evident is that the days of one-handle US 10-year treasury rates are over. It is not expected that this timid taper will suddenly result in a reversion to pre-Crisis yields as some would have nervous investors believe. Expert investment managers who have managed portfolios successfully through various interest rate cycles will tend to perform better than new fund managers, and investors would be wise to review their track record before making purchases in this environment.

Kevin Richards is Vice President, Sales and Marketing at Sterling Asset Management Ltd. Sterling is a licensed securities dealer and provides investment management and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm